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Through the Lens

The rise or demise of the machines?

18 August 2016

Have the underlying dynamics changed in Europe?

Finding yield for equity investors

Are there now opportunities in the banking sector?

Given concerns over growth, the European equity market looks fairly fully valued compared to longterm historical levels and we have seen de-ratings at both a market and company level. This has not been helped by challenging market liquidity levels. In part, this has been driven by what we term ‘the rise of the machines’ as ETFs have become a significant factor in market activity over the last four to five years. Conversely, this year we have seen some unwinding of this effect as volatility has weighed on trades and European equity ETFs have been adversely affected.

Another key concern has been the regulatory and capital pressures that have forced investment banks to deleverage and become more risk averse. With this reduction in liquidity has come increased volatility and weak investor sentiment.

Although there are questions over global growth (and we are undoubtedly in a world of low nominal growth) have the underlying growth dynamics changed that much? Post the financial crisis of 2008-9 and the sovereign bond crisis in Europe in 2011-12, we believe not much has actually changed and that what we are experiencing is in line with what we have seen over the last few years. There have not been great cyclical swings and we are fundamentally in a sideways trajectory. Cycles have been shallower but shorter, and while this often results in volatility there remain pockets of growth. We believe there continue to be opportunities for stock pickers to identify these areas of growth – something the machines can’t do.

As the demand for yield increases it is important to identify companies that have the potential to sustain or grow their dividends. Although the European banking sector has been through a period of turmoil and in some instances remains heavily indebted, opportunities remain.

After a period of restructuring, cost reduction and refinancing, which is key in a low growth environment a number of banks are now operating from a position of strength. Danske Bank has been through such a process, cost cutting and optimising its portfolio. It is now paying a 4.5% dividend yield, with an additional 4% capital return. Our view is that cash dividends act as useful checks on banks’ capital discipline and are very useful in enhancing shareholder returns (through both improved ROEs and multiples, as well as the cash payments). Encouragingly, and in spite of the headlines, there are examples of banks within Europe that have been able to weather the low interest rate storm. Danske Bank has operated in a negative interest rate environment for the last three years but over that period has restructured its business model, delivered strong capital generation, outperformed the market and increased its dividend.

We believe there are still attractive dividend yields to be found across Europe, particularly when compared with other income opportunities. Indeed, we expect the dividend outlook to evolve through the remainder of 2016. In the last few months, we have seen the banking and telecoms sectors, along with some industrials that have aggressively de-rated, offer scope for dividend upgrades. Identifying these opportunities is where the skill will lie and where active management can out manoeuver the machine.